Future of Financial Regulation - Banque de France · The Future of Financial Regulation. Banque de France - TSE conference . January 28, 2009. ... about future liquidity needs accrue.

SYSTEMIC RISK

Jean TIROLE

The Future of Financial Regulation

Banque de France - TSE conference January 28, 2009

I. INTRODUCTION

(At least) two meanings of systemic risk:

(a) Domino e¤ectsCreated by:

� mutual exposures[OTC markets, money market, etc.]

� absence of centralized exchange[Amaranth 2006 vs. Lehman or AIG 2008].

Highly endogenous.Peer monitoring and domino e¤ects two sides of the same coin?

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(b) Overall macroeconomic fragility

X Increased reliance on markets (securitization, money market):

� traditional institutions (commercial banks, broker-dealers)� shift from bank-based system to market-based system (shadow bankingsystem: conduits, hedge funds, investment banks, monolines;mutual funds: threats of redemptions).

X Subprime borrowers, LBOs.

X Strong monetary policy reaction:

� $4,400 billion commitments through various Fed facilities� Fed funds rate almost 0.

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(b) Overall macroeconomic fragility

X Increased reliance on markets (securitization, money market):

� traditional institutions (commercial banks, broker-dealers)� shift from bank-based system to market-based system (shadow bankingsystem: conduits, hedge funds, investment banks, monolines;mutual funds: threats of redemptions).

X Subprime borrowers, LBOs.

X Strong monetary policy reaction:

� $4,400 billion commitments through various Fed facilities� Fed funds rate almost 0.

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Emmanuel Farhi-Jean Tirole"Leverage and the Central Banker�s Put" (AER P&P 2009)+ larger paper (in progress)

Transformation, interest rate vulnerability and monetary bailout

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Key insight

Formal relationship between monetary developments andmarket-based �nancing:

"monetary policy" (interest rates)

� limited commitment� not targeted

the more economic actors exhibit interest-rate vulnerability, the morethe central bank must keep interest rates low.

Private leverage choices strategic complements through reactionof monetary policy

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Key insight

Formal relationship between monetary developments andmarket-based �nancing:

"monetary policy" (interest rates)

� limited commitment� not targeted

the more economic actors exhibit interest-rate vulnerability, the morethe central bank must keep interest rates low.

Private leverage choices strategic complements through reactionof monetary policy

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Key insight

Formal relationship between monetary developments andmarket-based �nancing:

"monetary policy" (interest rates)

� limited commitment� not targeted

the more economic actors exhibit interest-rate vulnerability, the morethe central bank must keep interest rates low.

Private leverage choices strategic complements through reactionof monetary policy

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Corollaries

Private leverage decisions highly sensitive to macroeconomicconditions.

Private sector interest-rate vulnerability may increase when bad newsabout future liquidity needs accrue.

Monetary policy time-inconsistent, not for standard in�ation-biasreason.

Need for macro-prudential supervision.

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II. DESCRIPTION OF MODEL

Choice of exposure to liquidity risk = choice between twotechnologies: "risky" and "safe". In practice:

reliance on securitization.

lack of hedging (purchase of protection),

failure to hoard assets or secure lines of credit.

Risky technology allows larger investment.

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II. DESCRIPTION OF MODEL

Choice of exposure to liquidity risk = choice between twotechnologies: "risky" and "safe". In practice:

reliance on securitization.

lack of hedging (purchase of protection),

failure to hoard assets or secure lines of credit.

Risky technology allows larger investment.

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II. DESCRIPTION OF MODEL

Choice of exposure to liquidity risk = choice between twotechnologies: "risky" and "safe". In practice:

reliance on securitization.

lack of hedging (purchase of protection),

failure to hoard assets or secure lines of credit.

Risky technology allows larger investment.

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CENTRAL BANK

Objective function

Can distort consumers�marginal rate of substitution between dates 1and 2, and lower (one plus) rate of interest R < R�. Distortion cost(MRS 6=MRT): L( R

(�)) = loss

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CENTRAL BANK

Objective function

Can distort consumers�marginal rate of substitution between dates 1and 2, and lower (one plus) rate of interest R < R�. Distortion cost(MRS 6=MRT): L( R

(�)) = loss

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MONETARY BAILOUTS

If �rm

has no cash at date 1 (extreme case: no store of value between dates0 and 1)

faces liquidity need,

then it must issue new securities on date-2 cash �ow.

Re�nancing constraint:

pledgeable incomeR

� reinvestment need (*)

Lower interest rate facilitates re�nancing. Let R0 < R� satisfy (*)with equality.

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MONETARY BAILOUTS

If �rm

has no cash at date 1 (extreme case: no store of value between dates0 and 1)

faces liquidity need,

then it must issue new securities on date-2 cash �ow.

Re�nancing constraint:

pledgeable incomeR

� reinvestment need (*)

Lower interest rate facilitates re�nancing. Let R0 < R� satisfy (*)with equality.

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∆ � β [bene�t for �rm from being able to continue]

�[reinvestment need� pledgeable incomeR �

]

X Bene�t of low interest rate policy is proportional to number of �rmsthat have chosen risky technology and are in distress:

X Cost of low interest rate policy L(R0) is �xed (independent of x)

Non-targeted policy

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∆ � β [bene�t for �rm from being able to continue]

�[reinvestment need� pledgeable incomeR �

]

X Bene�t of low interest rate policy is proportional to number of �rmsthat have chosen risky technology and are in distress:

X Cost of low interest rate policy L(R0) is �xed (independent of x)

Non-targeted policy

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∆ � β [bene�t for �rm from being able to continue]

�[reinvestment need� pledgeable incomeR �

]

X Bene�t of low interest rate policy is proportional to number of �rmsthat have chosen risky technology and are in distress:

X Cost of low interest rate policy L(R0) is �xed (independent of x)

Non-targeted policy

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Result #1. If ∆γx � L(R0)monetary bailout.

Strategic complementarities

Result #2. Time inconsistency(di¤erent from standard TI, à la Kydland-Prescott).

Result #3 Monetary bailout

Risky corporate behavior more likely if

higher weight of corporate sector in central bank�s objective (β high)

liquidity shocks more likely (γ high) ! contrast with commitmentsolution.

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Result #1. If ∆γx � L(R0)monetary bailout.

Strategic complementarities

Result #2. Time inconsistency(di¤erent from standard TI, à la Kydland-Prescott).

Result #3 Monetary bailout

Risky corporate behavior more likely if

higher weight of corporate sector in central bank�s objective (β high)

liquidity shocks more likely (γ high) ! contrast with commitmentsolution.

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Result #1. If ∆γx � L(R0)monetary bailout.

Strategic complementarities

Result #2. Time inconsistency(di¤erent from standard TI, à la Kydland-Prescott).

Result #3 Monetary bailout

Risky corporate behavior more likely if

higher weight of corporate sector in central bank�s objective (β high)

liquidity shocks more likely (γ high) ! contrast with commitmentsolution.

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Regulating leverage

X With commitment, no need for leverage regulation:

� privately and socially sub-optimal to start a risky project that is dis-continued in case of distress

� privately and socially optimal to choose risky project if monetary bailout

X Without commitment, leverage regulation to alleviate temptation tobail out.

Macro-prudential regulation

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Regulating leverage

X With commitment, no need for leverage regulation:

� privately and socially sub-optimal to start a risky project that is dis-continued in case of distress

� privately and socially optimal to choose risky project if monetary bailout

X Without commitment, leverage regulation to alleviate temptation tobail out.

Macro-prudential regulation

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FISCAL BAILOUTS

X Di¤erent kind of ine¢ ciency. Can be targeted. But (due toinformational limitations) consumer money may end up subsidizing�rms that don�t need it.

X Monetary and �scal bailouts. May be complements.

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FISCAL BAILOUTS

X Di¤erent kind of ine¢ ciency. Can be targeted. But (due toinformational limitations) consumer money may end up subsidizing�rms that don�t need it.

X Monetary and �scal bailouts. May be complements.

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